FreightWaves contributor Jim Blaze has already declared that we are in a recession for U.S. rail freight. And if we're talking strictly volumes, there's not much to argue with – volumes have been ugly. But, like so much else in life, it depends on one's perspective.
Shareholders are still happy, with Union Pacific (NYSE: UNP) and Kansas City Southern (NYSE: KSU) beating the S&P Index over the past 12 months (see graph below), and beating it handily in the case of Kansas City Southern. Rail volumes are visible each week and the volume declines throughout the third quarter caused analysts to cut estimates. Yet, fears that lower volumes would disrupt the railroads' ability to improve margins were once again unfounded.
That was achieved with further dramatic improvement to cost structures and fluid networks during the quarter. As a result of the strong results, railroad shares are back to trading near all-time highs both in absolute terms and on forward price-earnings multiples. Adding to Blaze's comments, it should be stressed that when recessionary conditions are described in rail, it is a reference to a "rail traffic recession" or "rail volume recession"; earnings per share (EPS) for Norfolk Southern Corporation (NS), Union Pacific (UNP) and CSX grew an average of 2% year-over-year (y/y) in the just-reported third quarter of 2019, a slower pace than the double digit earnings growth the industry has become accustomed to seeing, but not recessionary.
From other perspectives, rail workers whose jobs were cut (rail employment in September 2019 was 9% below year-ago levels) as a result of cost reduction efforts might say that Blaze undersold it – and that there really is a rail depression. Meanwhile, shippers' attitudes are likely mixed, satisfied with current service levels, dissatisfied with still-rising rates on carload traffic amid declining volumes, and concerned that railroad capital budgets have been cut too much to effectively handle an eventual surge in volume.
Source: SONAR, stock.nsc,stock.csx,stock.spx, stock.unp, stock.ksu
Railroad Earnings Math (Or Why It's Good To Be A Class I Railroad)
Remarkably, the largest public U.S. Class I rails (CSX, UNP, NSC) grew EPS an average of 2% y/y in the face of overall unit volumes being down an average of 6% y/y. The railroads' core pricing (excludes fuel and mix) improved 2%-4% y/y for the railroads that still report such a metric; the ability to raise prices and improve yields even in a traffic recession is one thing that continues to set the railroads apart from other transportation modes and is also the best way to improve operating ratio.
Speaking of operating ratio, the railroads scaled down their operating expenses more than proportionately with their revenue declines and the three largest railroads improved their operating ratios an average of 150 basis points from the prior year. Net income declined by 4% y/y as a result on average, but EPS improved 2% y/y with share counts 6% lower y/y from share repurchases.
Is There Any Way To Positively Spin The Deteriorating Rail Volumes?
The deteriorating rail traffic has been highlighted in recent weeks but, simply put, growing volume and revenue is not the U.S. rails' top priority currently – reducing the cost structure and improving the operating ratio are. By those measures, the railroads have exceeded expectations this year and the share prices reflect that.
Emulation of the late Hunter Harrison and his precision scheduled railroading, or PSR, are antithetical to growing volumes, providing strong customer service and having a capacity cushion to handle a surge in volume. Rather, the rails are engaging in "yield management" initiatives (repricing rates higher in lanes that are less competitive with another railroad or mode) and have been de-marketing intermodal lanes that were earnings a sub-standard margin (although, the railroads claim that process is behind them). Brad Jacobs, CEO of XPO Logistics, recently said the U.S. is in an industrial recession. It appears that the railroads are purposefully taking less volume than they could.
Unit Volume Versus Last Year Is A Bloodbath Across The Board...
Source: FreightWaves SONAR, RTOIC.CLASSI
But Rail Employment Is Down More Than Carloads
Source: FreightWaves SONAR, EMPN.RAIL, RTOTC.USA
A Silver Lining To Lower Volume – Improved Fluidity
There are lessons from Hunter Harrison's career that resonate – an empty rail yard is a good thing; it means that assets are being "sweated" in the field. And Harrison believed in running trains at higher speeds – which leads to improved asset utilization and less congestion.
FreightWaves SONAR data shows both of those metrics emphatically moving in the right direction, which indicates a greater degree of asset utilization and an imperfect, but still meaningful, measure of solid customer service. The railroads are also making headway on operating metrics like train length and cost metrics like gross ton miles (GTMs) per employee. Of course, these metrics are being helped by the lower traffic volumes and, at some point, the railroads will have to show that they are as good at scaling up for greater volumes as they are at scaling down for lower volumes.
Velocity Is Up And Dwell Is Down – Both Good Things For The Railroads
Source: FreightWaves SONAR, RAILSPEEDSYS.CLASSI
Recession or Recovery in 2020? Each Path Presents Its Respective Challenges
The only thing known for certain about 2020 at this point is that the Summer Olympic Games will be held in Tokyo; otherwise, uncertainty abounds. Perceptions of long-term rail traffic growth is that rail traffic is "GDP-minus," or should grow at a slower rate than the overall economy. This is due, in part, that much of the tonnage that railroads move are slow-growth, no-growth commodities or decliners (coal) over the long-term. In addition, intermodal has a diminished status as an avenue for growth, at least for now.
History shows that rail traffic declines when the industrial economy is in contraction and grows when the industrial economy is in expansion. Accordingly, 2019 U.S. rail traffic is down ~4% year-to-date with the latest ISM of 47.8 in September, indicate a contraction in the industrial economy.
To simplify, the railroads will have to deal with one of two broad scenarios going forward, each presenting a unique set of challenges: either rail traffic will start to enter positive territory on a y/y basis upon lapping the steep declines that started in earnest in early 2019; or the rail traffic recession will become more severe, perhaps becoming an economy-wide recession.
History shows that the railroads will respond to further volume declines similarly to how they have been responding of late, with cuts to expenses to preserve margins as much as possible. In recent years, the railroads have become better at being nimble with expenses, creating a more variable cost structure – leasing a greater portion of equipment and employee furloughs are examples.
If volumes expand or recover, that will create its own set of challenges, even if that is a problem the railroads would love to have. It remains to be seen whether the railroads have cut "into the bone" when reducing expenses and capital budgets; will the railroads be able to effectively handle an eventual surge in rail traffic when it eventually comes? Recall that it was only a year and a half ago that Canadian National Railway failed to deliver grain to the Port of Vancouver, leading to the ouster of its CEO. I believe the strong current operating metrics and satisfactory service levels are at least partially due to the lower traffic levels. Is there enough redundancy built into the system to effectively handle an eventual traffic surge, particularly if it is concentrated in a particular region or commodity?
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